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Why the 4th Quarter Wasn't Good Enough for Lowe's, and What Its Management Is Planning to Do About It

It's not that there was anything especially wrong with Lowe's Companies, Inc.'s (NYSE:LOW)fourth quarter. It was just that it was, once again, overshadowed by the quarter of its larger competitor, Home Depot Inc.(NYSE:HD). The fourth quarter at Lowe's, when viewed by itself, was a decidedly mixed bag.

The good news was that comparable sales increased 4.1%. The bad news was that the increase came wholly from a 4.9% rise in average ticket price; customer transactions decreased 0.8%. Net sales for the quarter were $15.8 billion and adjusted EPS was $0.74 -- both small decreases year over year, but that's mostly explained by a 14-week quarter in 2016, rather than a 13-week one. More concerning was the decline in the company's gross margin, which fell to 33.73%, a 38-basis-point year-over-year decrease.

Lowe's Metrics

2017 Q4

2016 Q4

Change (Loss)

Net sales

$15.49 billion

$15.78 billion

(1.8%)

Adjusted EPS

$0.74

$0.86

(14%)

Gross margin

33.7%

34.4%

(70 basis points)

Data source: Lowe's Companies, Inc.

None of these numbers compare favorably with Home Depot, which saw increases in sales, EPS, average ticket price, and customer transactions, but that doesn't mean Lowe's management is willing to cede the fight. CEO Robert Niblock promised during the company's conference call that it will move with "urgency" to analyze the company's performance and determine the best way forward.

While Niblock went through a six-point strategy encompassing a host of strategic initiatives, I believe the three most pressing for investors are the effectiveness of sales associates, a new marketing strategy, and better inventory control. Let's take a closer look at what Lowe's management is planning to do in these three areas.

Missed sales

Perhaps the biggest problem with the fourth quarter was that the number of customer transactions was down almost a whole percentage point. Management insisted this wasn't because traffic was down, but that the store was failing to convert foot traffic into actual sales. While that assertion probably deserves a healthy dose of skepticism, for now let's take it at face value. If customers are in the stores, why can't Lowe's close the deal?

Chief Operating Officer Richard Maltsbarger said in his opening comments during the conference call that earlier in 2017, the company realized it lacked the proper floor coverage by sales associates during key weekend and holiday sales but that the company has not realized the benefits from those investments yet. He also said the company recognizes that addressing this problem will require more than just additional payroll. When pressed during the question-and-answer session, Maltsbarger responded:

First and foremost, it's really the mix of our selling and tasking hours. How do we go about getting the work done in our stores every day to enable our red-vest associates to be in front of the customer when it's time to serve? Second focus we have on ... is having the labor hours in the store necessary, having associates ready through our training and our knowledge programs to be ready to serve is just as necessary. ... Third, re-engineering some of our key processes. ... We have an upgraded experience both in the physical layout as well as in staffing and training model going out in Q1 ... an opportunity to speed up our process ... for our in-store associates to allow them more time to serve the customers that are with them every day. And then finally, upgrading our digital management tools, giving a chance for our associates to get more productive with the hours that we invest into tasking.

A new marketing strategy

Maltsbarger promised that the company is shifting its marketing strategy, saying, "We've also continued our evolution from analog to digital marketing, delivering more personalized, targeted messages." This is one area where Lowe's appears to be painfully behind its larger rival. At its recent investor day, Home Depot management claimed to generate 1.7 trillion data points on its more than 50 million active customers each week, all for the purpose of generating personal marketing pitches to different customers. The company's "enhanced marketing management platform" just went live this past quarter and is expected to drive traffic growth throughout the coming year.

Better inventory management

During the quarter, inventory turnover was 3.9, down from 4.05 a year ago. Inventory levels increased 8.9% to $11.4 billion this quarter. When inventory levels grow faster than sales, gross margin comes under pressure, and if the trend doesn't improve, Lowe's will probably suffer from a decline in gross margin again next quarter. When asked about inventory management, company leaders promised they were focused on it, were working on it, and were investing in it -- but seemed to offer little specifics beyond converting more traffic to sales.

When asked, Maltsbarger did say the goal for the year was to have inventory levels rise less than sales in 2018. He also said the "onus is on me" to understand what changes needed to be made between the supply chain and the company's store locations to better deliver products to "a shoppable position" for customers. While that's fine as far as it goes, more specifics on what some of these actions could entail might have better served shareholders.

A second-place finish in a two-horse race

Again, there's nothing inherently wrong with investing in Lowe's when compared with the entire retail sector. Based on the midpoint of its full-year EPS guidance of $5.45, Lowe's currently trades at a relatively attractive forward P/E ratio of 16. The company still pays a well-covered and rising dividend. The problem is that Home Depot appears to be several steps ahead of its home-improvement rival at this point. Given its better growth and execution, it's hard to pass over Home Depot for Lowe's based on a slightly more attractive valuation. While the steps Lowe's is taking will probably improve its prospects, I would rather wait to see the proof before trusting the company's management with my investment dollars.

Matthew Cochrane owns shares of Home Depot. The Motley Fool has the following options: short May 2018 $175 calls on Home Depot and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Home Depot and Lowe's. The Motley Fool has a disclosure policy.

Author

As an economic crimes detective, Matthew focuses on helping others from becoming victims of fraud and scams. He is most familiar with the fintech and payments industry and devotes much of his writing to covering these two sectors.
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